Solvency II: What It Means in Europe and U.S. Today

Solvency II is an ongoing European initiative to develop an asset risk-focused set of regulatory capital requirements and hold insurers to a higher bar with new capital standards on riskier assets. Its predecessor, Solvency I, was a simple factor-based model. Solvency II has been underway since the adoption of Solvency I back in 2002.

It is slated to become law in October of this year and go into effect, in part, in January of 2013. After January there will be supervisory requirements and undertakings before full implementation comes into force the following year.

Under Solvency II, solvency requirements will also be more comprehensive than in the past, according to the European Commission’s FAQs. Insurers will now be required to hold capital against market risk to protect against a fall in the value of insurers' investments, credit risk and operational risk (for example, risk of systems breaking down or malpractice).

EU solvency requirements currently concentrate mainly on the liabilities side (i.e. insurance risks).

However, Solvency II will weigh asset-side risks. The new regime will be a 'total balance sheet' where all the risks and their interactions are considered, the European Commission states.

Solvency II also emphasizes that capital is not the only or the best way to mitigate against failures.

New rules will for the first time compel insurers specifically to focus on and devote significant resources to the identification, measurement and proactive management of risks.

However, there are a few knots to untie before full implementation.

An NAIC staff paper on financial solvency presented during an NAIC meeting with the Federal Insurance Office (FIO) in December of last year stated: Solvency II is still a few years away from being “operational.”

Specifically, the European Parliament is considering, in closed parliamentary review sessions between now and September, something called Omnibus II, a consideration of certain proposals and tweaks to Solvency II, including relief on certain equivalency standards and the impact of changes to risk-free interest rates for long-duration contracts. A vote has been postponed until the last date that it can be conceivably done.

The Omnibus II proposal also includes the provision for the European Insurance and Occupational Pensions Authority (EIOPA) to provide technical standards between September 2012 and December 2016.

“These [technical] standards are wide ranging, covering areas such as own fund classification, valuations of assets and liabilities as well as capital requirements, supervisory reporting and capital add-ons,” states consultancy Towers Watson on its "Advice for Insurers on the EU Directive" webpage.

This matters because without postponement or relief, an insurer would have to make its entire nondomestic subsidiaries conform to Europe’s Solvency II requirements.

A person in the life insurance industry who is familiar with the topics being discussed noted, “I think Aviva is considering leaving or putting out a trial balloon about leaving because they’re not sure what the European Parliament is going to do with the equivalency.”

And the NAIC shares those concerns. “To the extent that Europe might not find our system of supervision equivalent, it could have negative implications on U.S. insurers doing business in Europe and European insurers doing business in the U.S.,” the NAIC staff paper states.

Solvency II is based on a three pillar approach which is similar to the banking sector (Basel II) but adapted for insurance. Both require high levels of capital for insurers in a way that some say does not fit the insurance industry.

As international regulatory arena veteran Terri Vaughan, PhD, president of the NAIC, described in a policy paper, with a simple factor-based model, the required regulatory capital requirement is a function of premium writings and loss reserves for property/casualty insurance and the sum at risk for life insurance.

“Recognizing the limited risk sensitivity of this approach, particularly its failure to recognize asset risks, it became clear even during the development of Solvency I that a more comprehensive approach was necessary. After several years of work, the European Commission adopted the Solvency II Directive Proposal in July 2007 and amended the proposal in February 2008,” Vaughan explained back in 2009, when implementation was set for 2012.

According to the European Commission, the first pillar contains the quantitative requirements:

Pillar 1: There are two capital requirements, the Solvency Capital Requirement (SCR) and the Minimum Capital Requirement (MCR), which represent different levels of supervisory intervention. The SCR is a risk-based requirement and the key solvency control level. Solvency II sets out two methods for the calculation of the SCR: the European Standard Formula or firms' own internal models. The SCR will cover all the quantifiable risks an insurer or reinsurer faces and takes into account any risk mitigation techniques. The MCR is a lower requirement and its breach triggers the ultimate supervisory intervention: the withdrawal of authorization.

Pillar 2: The second pillar contains qualitative requirements on undertakings such as risk management as well as supervisory activities.

Pillar 3: The third pillar covers supervisory reporting and disclosure. Firms will need to disclose certain information publicly, which will bring in market discipline and help to ensure the stability of insurers and reinsurers (disclosure). In addition, firms will be required to report a greater amount of information to their supervisors (supervisory reporting).

Solvency II will also change the economic reality of how groups operate.

The new regime will strengthen the powers of the group supervisor, ensuring that group-wide risks are not overlooked and demand greater cooperation between supervisors. Groups will be able to use group-wide models and take advantage of group diversification benefits.

“Solvency II includes an assessment of equivalence with regard to three distinct areas of a “third country” (i.e., non EU) solvency regime, as the NAIC points out and that is where the U.S. comes into the picture and where the relationship between the US and Solvency II gets complex.

The NAIC’s regulators believe that based on the strength of the U.S.’s existing system and the ongoing process of refinements to areas like group supervision and reinsurance through the NAIC’s extensive Solvency Modernization Initiative (SMI) effort, the U.S. system of supervision is at least equivalent to Solvency II on an "outcomes basis. This is meant to respect the different cultural, legal and regulatory environment that exists in the U.S.

SMI was announced in June 2008 with one of its objectives being an articulation of the U.S. insurance financial solvency framework. It is intended to highlight the strengths of the state-based national system of insurance regulations and identify improvements that might be made. All work on the project is expected to be completed by year-end 2012.

The NAIC has been pushing past the strictures of equivalency for some time and may have arrived at a different level of recognition with the EU.

“Although the U.S. insurance regulators do not intend to implement Solvency II in the states and there are clear differences between the regulatory and legal structure of our markets, we do believe that our system of supervision is at least equivalent to Solvency II on an outcomes basis,” it has stated.

The equivalence process in relation to the EU's Solvency II initiative has been and will continue to be the subject of ongoing dialogue between U.S. and EU supervisors.

The European Commission wrote in February that a different approach for equivalence in relation to the US would need to be adopted.

The February letter from Jonathan Faull, Director General Internal Market and Services for the European Commission, to Gabriel Bernardino, chair of EIOPA, identified Australia, Chile, Hong Kong, Israel, Mexico, Singapore and South Africa as “third countries” that have expressed interest in being part of the transitional regime to Solvency II.

But, with regard to the U.S. relationship, representatives from the European Commission and Bernardino met with the representatives from the FIO and the state insurance regulators recently to define a work plan, “which would lead to increased mutual understanding and co-operation in the insurance sector for the benefit of consumer protection, business opportunity and effective supervision,” the letter from Faull to Bernardino noted.

“Therefore, as recognized in the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) previous technical advice, it is clear that a different approach for equivalence in relation to the US would need to be adopted,” stated the letter.

CEIOPS is composed of high-level representatives from the insurance and occupational pensions supervisory authorities of the European Union's Member States.